Internalizing Externalities in Second-Best Tax Systems

We analyze the analytical structure of optimal taxation of polluting and non-polluting goods in a second-best world where lump-sum taxes are infeasible. After deriving the environmental tax rate which exactly internalizes the external effect, we show how to separate the analysis of second-best optimal environmental taxes from the analysis of the tax structure which minimizes the excess burden. This separation reveals that standard results of optimal taxation essentially carry over to economies with externalities. Our approach clarifies the controversy regarding the relation between the first-best Pigovian tax rate on polluting goods and the optimal tax rate in a second-best world.